The top-down approach is a valuation approach that begins with first analyzing the overall economy and then continuing to drill down to the specific analysis. The idea behind the top-down approach when valuing securities is to start from a high level analysis: the general economic conditions. The next step would then be to analyze a specific industry within the economy. Last, an investor would compare and analyze specific securities to invest in.
The top-down approach allows an investor to make an informed investment decision based on a keen understanding of the economy and industry and how that relates the stock, versus comparing the stocks fundamentally against their peers without thinking about the overall movement in the market.
The top-down approach can be particularly useful when analyzing the valuation of world stocks. Given the starting point of understanding the world economies, an investor is able choose an appropriate stock based on areas of the world that may be doing better. a
The Different Forms of Investment Returns
When considering an investment there are various forms of investment returns that could be used, depending on the type of asset being evaluated. For example, when valuing a Real Estate Investment Trust (REIT), a price to cash flow metric may be more important as a measure of return. For a stock, dividend income or earnings may be an appropriate form of return to analyze. For bonds, an investor may consider cash flow.
The important thing to keep in mind at this point is maintaining consistency with the form of investment return used. We'll discuss the various forms of investment returns in detail within the remainder of this book.